Not-So-Special Effects

Losses Influence A Portfolio Disproportionately More Than Gains

William Davis and Daniel Snover

Successful investors will tell you they probably think more about losing money than they do making money. Not that they’re ignoring the hard task of finding winners. They are not. The goal, after all, of anyone with money in the market is to make more money. But what the prosperous crowd never ignores What they are, though, is obsessive about avoiding losers. Protecting what they have, in other words.

Why? Well, as with most great truths, the answer is simple: Losses have an unpleasantly disproportionate effect on wealth.

The recovery numbers are, of course, asymmetric. At small levels of loss, the gain needed to break even is only incrementally larger. But as the loss percentages grow bigger, it becomes a whole different ballgame. At the extreme, the numbers become outlandish as there’s only tiny amounts of capital left to recover. But all you have to do is push the chart out to a 50% decline (a number not totally out of the realm of possibility, by the way) and the math shows it will take a 100% recovery— a double on portfolio value – to break even. It’s not real easy to lose 50%, of course, but it’s a heckuva’ lot easier than gaining 100%.

Bottom line: Losses are much more damaging than gains are helpful. Which is why great investors focus as much on playing defense as they do offense.

THE RISK OF UNFORTUNATE TIMING

Disappointingly, the message of the math tends to be forgotten on lots of folks, especially after extended periods of forward- or sideways-moving markets. Why? Because, these are frightening numbers, especially when considering the number of large drawdowns equity markets have suffered over the last 40 years.

While the Financial Crisis of 2008/2009 may be closer to front of mind, it’s worth recalling a particularly nasty stretch earlier in that decade when the NASDAQ Composite lost 78% from its high on March 10, 2000 to its low on October 10, 2002. That out sized hit meant an investor in the index needed to earn nearly 400% – or five times the remaining capital – just to get back to even.

As it turned out, it took the NASDAQ more than twelve and a half years to climb back to its March 2000 high.

Most investors don’t have that kind of time to wait for a recovery. Many didn’t. It’s likely the millions of people heading for retirement when the market began sinking in 2000, and again in 2008, never really recovered.

That’s because they took the full brunt of what’s called the sequence-of-returns risk – when the value of a portfolio tanks at the moment an individual is launching in to the “distribution” phase of investing, i.e., withdrawing assets for day-to-day living expenses and other issues.

Sadly, this unfortunate event decimates an investor’s financial quality of retirement life for a very long time. Maybe all their time. Worse – beyond having a shrunken pile of assets to pay for things – these investors will be left with a smaller portfolio to participate in the rebound that inevitably follows.

The WEALTH DRAG FROM Volatility

So, what do great investors do to avoid such a bad luck of the draw? Simple. They’re always prepared to “win by not losing.” One of the more effective mechanisms to that end is utilizing strategies with controlled volatility.

It can be shown mathematically (the variance drag calculation) how a portfolio with lower volatility will have a higher compound return compared to a portfolio with high volatility – even if they have the same average return. The range of returns, in other words, is much more important than the average return. Here’s why:

Consider two hypothetical investments — one that has produced an average annual return of 6.25% and one has produced 3.00%, less than half the former. An easy investment choice at first blush. But what these top-line numbers don’t reflect is how frequently and to what degree the two investments lost money in a given year.

Assume, then, the two investments have produced the following returns over a four-year period:

Investment No. 1, while producing big gains in two of the four years, also loses money in two out of four years. Investment No. 2, meanwhile, never produces a big up year but never loses money either. Arithmetically, the owner of Investment No. 1 enjoys a much higher average return. But volatility, in this hypothetical example, proves very damaging to the owner of Investment No. 1.

It turns out that Investment No. 2 has a noticeably higher compounded annual return. Compounded annual returns – which multiply the four returns together rather than simply adding them and dividing by four – consider the asymmetry of gains and losses. A portfolio’s compounded return is the number that counts when measuring wealth accumulation.

The owner of Investment No. 2 – because it is much less volatile – creates more real wealth.

THE RELEVANCE OF MANAGING DRAW DOWNS

In the real world, it’s very difficult to recover from even one large loss, the consequence of which could destroy the beneficial effects of many years of investment success. It’s easy to suggest that an investor will be better served by achieving consistently good returns with limited downside risk than by achieving spectacular gains with substantial risk.

Consider, again, the math: A hypothetical investor who earns 16% annual returns over a decade ends up with more money than an investor who earns 20% a year for nine years and then loses 15% the tenth year.

So, when you hear someone trumpet average returns, be very skeptical. Insist that that they provide you with not only their geometric compounded returns, but also the range of their returns so you can see exactly how often – and to what degree – they incur damaging losses. Only without market volatility does the sequence of returns risk become irrelevant.

THE MOST IMPORTANT THING

It was famously said, by a notoriously successful short-term trader no less, that the most important thing in any investment strategy is how good is its risk control. We’re known to be long-term folks, of course, but we couldn’t agree more. Managing volatility and keeping losses to a minimal level is paramount among the many challenges of good investing.

But meeting the challenge is no easy task. Finding portfolio investments that have low or negative correlation to each other – on a continual basis – is hard. A lot harder than simple buy, hold, and pray-the-market-never-goes-down kind of portfolio management.

What we’re talking about here is combining investments with positive expected return and relatively high volatility in a way that minimizes portfolio volatility while not degrading returns. And doing so in a systematic, repeatable way that adjusts to current market conditions.

No investor should be asked to “hold on” through dramatic market downswings. We might suggest a well-articulated strategy that, in addition to capturing a fair amount of the market’s upside, seeks to minimize drawdowns in a systematic way, with definite entry and exit points in place.

It’s the best way we know to win by not losing.

FACOM-021017

The views in this commentary are those of Fund Architects. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product made reference to directly or indirectly in this commentary, will be profitable, equal any corresponding indicated historical performance level(s), or be suitable for your portfolio. Moreover, you should not assume that any discussion or information provided here serves as the receipt of, or as a substitute for, personalized investment advice from Fund Architects or any other investment professional. The information contained within this commentary should not be the sole determining factor for making investment decisions. To the extent that you have any questions regarding the applicability of any specific issue discussed to your individual situation, you are encouraged to consult with Fund Architects. Information pertaining to Fund Architects advisory operations, services, and fees is set forth in Fund Architect current disclosure statement, a copy of which is available upon request. Fund Architects, LLC is an SEC Registered Investment Advisory Firm.